N.Y. proposes the first regulatory system for virtual currency exchanges

New York’s financial services department has proposed the first regulatory framework for policing virtual currency businesses.

Under the proposed rules, any New York businesses that store or exchange virtual currencies, such as Bitcoin, would first need to obtain a license from the state, Benjamin Lawsky, the state’s financial services superintendent, said Thursday. Lawsky says the so-called “BitLicense” would be meant to protect consumers who deal with virtual currency exchanges without slowing down innovation by those businesses.

“We have sought to strike an appropriate balance that helps protect consumers and root out illegal activity – without stifling beneficial innovation,” Lawsky said in a statement. “Setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets.”

Licensed virtual currency firms would be required under the proposed rules to hold the same amount of virtual currency that they owe to customers without selling or loaning it out to anyone else.

The proposed guidelines would also mostly eliminate virtual currency users’ ability to remain anonymous, as all licensed businesses will need to maintain and submit records of virtual currency transactions that include all parties’ names and addresses. That particular wrinkle is part of the state’s compliance program meant to stamp out the use of virtual currency for money laundering.

The state, which said earlier this year that it would come out with these guidelines by the end of the year’s second quarter, has submitted the proposal for public comment. The full framework will be published for public view on July 23 and will remain open for comment for 45 days from that point, Lawsky said.

Is the Fed quietly planning new bitcoin regulations?

FORTUNE — When Janet Yellen stated in February that the Federal Reserve had no authority to regulate bitcoin, many fans of the virtual currency were elated.

After all, for many believers in virtual currency, the Federal Reserve is enemy No. 1, an institution that has so badly mismanaged the U.S. dollar as to necessitate the creation of a decentralized currency like bitcoin.

But the idea that bitcoin could ascend to the status of a leading global currency without government regulators is naive. Even bitcoin booster and investor Barry Silbert has argued that the next stages of bitcoin’s development will involve big Wall Street banks getting in on the action by, for instance, setting up ETFs and other products that will facilitate the currency’s rise.

And recently released minutes from a Federal Reserve Advisory Committee meeting in early May suggest that the Fed foresees a similar trend, which would necessitate federal bitcoin regulation.

The Advisory Committee can’t dictate policy — it’s assembled to help voting Fed officials benefit from and understand the concerns of the banking industry — but the minutes can shed light on what Fed policy might look like in the future.

Indeed, even Yellen’s argument in February that the Fed didn’t have the authority to regulate bitcoin was based on the the idea that currency was an “innovation happening outside the banking industry.” If Fed-regulated banks are in fact looking to get involved in bitcoin, this reasoning is no longer valid.

The Advisory Committee is composed of elite members of the banking industry, so the body is better equipped to understand its plans than most. And according to the minutes, the committee agrees with Silbert that incumbent banks will have a role to play in bitcoin’s future, concluding, “Should adoption accelerate, banking could participate increasingly in Bitcoin fund flows, especially as multicurrency accounts proliferate and reputational concerns subside.”

Though the committee didn’t offer details on how the banking industry might incorporate bitcoin into its business, it was optimistic about the currency’s potential effect on the economy:

Bitcoin does not present a threat to economic activity by disrupting traditional channels of commerce; rather, it could serve as a boon…. Its global transmissibility opens new markets to merchants and service providers…. Driving capital flows from the developed to the developing world should increase consumption.

Clearly, the bankers advising the Fed understand the bull case for bitcoin, though they argue that it is still too small a phenomenon to pose any sort of risk to the U.S. economy, calling it “more a curiosity than a threat.” They foresee more consumers adopting bitcoin only if it can prove to be cheaper, faster, and more geographically flexible than alternative modes of transmitting money, and they see bitcoin doing this with the help of the financial services industry rather than in spite of it.

When consumers and the financial industry do come on board, the Committee advises regulating it much like other financial services products, like supervising bitcoin exchanges with “requirements for business continuity planning,” and “a forum for fraud prevention and disclosure of bitcoin’s risks and costs.” It also recommended that bitcoin businesses be subject to anti-money laundering regulations, just as banks are.

These measures, of course, could greatly increase costs for companies that deal in bitcoin, costs that would have to be passed on to end users. And since one of the main arguments for bitcoin is its lower costs for online transactions, these measures would surely undercut some of the reason to use it. These minutes underscore a central tension in the bitcoin story: it is a technology whose popularity is tied to its ability to undercut the government and incumbent financial industry’s role in currency and money transmission, but one that clearly needs the blessing of both to reach its full potential.

The clock is ticking on Bitcoin

If you want a chicken pita from Meze Grill in midtown Manhattan today, you can fork over $8.75 or give them about half a bitcoin. The restaurant began accepting bitcoin Tuesday and its owner is excited, although a manager on Wednesday said that so far, no customer had paid this way.

Bitcoin is an unregulated, peer-to-peer currency that only exists online; it may sound like a concept out of Mario games or The Matrix. It was started in 2009 by a programmer known by the pseudonym Satoshi Nakamoto. And a few weeks ago most people had never even heard of bitcoins.

But a story from Gawker about the drug website Silk Road, which uses bitcoin as its payment method, brought the currency into the mainstream. Now Senators Chuck Schumer (D-New York) and Joe Manchin (D-West Virginia) are demanding a crackdown. Last week, they wrote Attorney General Eric Holder a letter that expressed fears about both Silk Road and bitcoin, pointing out that Silk Road’s method of payment is “an untraceable peer-to-peer currency,” adding that it’s “an online form of money laundering.”

But bitcoin isn’t really “untraceable,” and many of its uses have nothing to do with Silk Road.

In simple terms, here’s how it works: Using a platform such as Dwolla, users can convert money from a credit card into bitcoins. From there, they can enter online bitcoin exchanges like Mt. Gox Bank and trade with others. Mt. Gox functions essentially like a stock exchange floor that allows bartering and setting your own rate, though most people adhere to an average rate (as of writing, the rate was around $19 per BTC). There are no names used, but every transaction is visible at a public page, where users are identified by public keys.

Bitcoins, which can be purchased with any currency, have grown steadily in value since they launched in late 2009, when they were worth about 5 cents. Since then, the currency has had volatile ups and downs but never a full crash. Proponents say that the currency is built to resist inflation because the entire supply is capped at 21 million bitcoins — there will never be more created, though they can be sub-divided up to eight decimal places.

Who’s really making money from this? “The people who have made the most are the early adopters who got in at the beginning and stayed with it,” says Bruce Wagner, an IT expert who spotted bitcoin in 2010 and says he “became obsessed.” He created Bitcoinme.com, a “bitcoin for dummies” site that explains step-by-step how merchants can accept bitcoin. The site was translated into twelve other languages within a week. “But because of the anonymous nature, no one really knows who they are,” says Wagner. “There are addresses that have enormous numbers of bitcoins, you just don’t know who owns them. I know a guy in Brazil who bought $20 worth of bitcoin when it was at half a cent, so you do the math.” (That buyer’s investment is worth nearly $80,000 now.)

The exchanges are making money too, though just how much is another unknown. Mt. Gox charges 0.65% per trade, while TradeHill, another exchange that has popped up, charges less if users have a referral code for 10% off, which most do, and is good on all trades for life.

Now there are even other bitcoin-like currencies, such as namecoins, which are bought with bitcoins and used to pay for domain name hosting. Some traders believe the biggest potential now is in the limitless creation of these e-currencies.

Limited shopping options

At the moment, bitcoins can’t really be used at any mainstream retailers. Based on this wiki list of businesses that accept bitcoin, you can use the currency to buy real goods and services, but we’re not exactly talking about Amazon.com . The vast majority of these little known sites have names that begin with the word “bit,” and many are programming businesses that sell web site design services or domain hosting.

Of course, Meze Grill is an exception — one of the few brick-and-mortar stores jumping onto the bitcoin bandwagon early. The owner, Marwan Salem, heard about bitcoin months ago from Wagner, who was a regular customer. Salem used Wagner’s web site to set up Meze Grill’s QR code, which they keep on a laminated sheet behind the register. A customer can then pay with BTC via any bitcoin exchange app (they exist, for now, only for Android, the operating system of choice for true techies).

But the value of the bitcoin could sink the day after a customer pays with it, so the store would have effectively charged too little. If they really wanted to ensure they aren’t losing money from sales paid with bitcoins, they’d have to watch the exchange rate closely and adjust their price every single day. “Yeah, that is the only catch,” says Jose Vega, a manager at Meze. “But it is a big catch.”

The controversy over bitcoins intensified this week, when a trader posted on a forum that he had been robbed of around $500,000 worth of the currency. It happened because a prime way to store bitcoins is in a “wallet” file that sits on a computer’s desktop and, like a real wallet, can be stolen if left unprotected.

Who are these bitcoin owners? “I don’t think there is a prototypical bitcoin user,” says John Robb, a Boston-based entrepreneur who was a Forrester tech analyst in the early days of the Internet, and has watched bitcoin closely since its inception. “There are a bunch of Libertarians in there, or people who like gold. A lot of people are just doing it for the fun.”

The regulatory question

While its fans praise the lack of regulation around bitcoin, there are possibly as many traders who want it regulated, and see potential for it as a legitimate global currency. “It could get much more mainstream with the creation of more exchanges, like Mt. Gox or TradeHill,” says Mark Oates, a computer programmer in Oklahoma. “If you were a merchant and you wanted to begin accepting it, you’d be taking a risk. It’s like when credit cards first came out.”

Oates, 30, read about bitcoin on a tech forum and asked his parents to invest with him two weeks ago. He converted about $2,000 and is letting it sit. He likes that the currency can’t be forged, that each bitcoin transaction is logged on a public chain, and that “it encourages saving instead of spending.”

Robb points out that it shouldn’t matter whether BTC goes mainstream or not; it’s already a success and, he claims, maybe even a safeguard against a collapse of the dollar. “The thought that it has to be globally accepted is an old way of thinking,” he says. “If you don’t get it, your loss. The same thing happened when the Internet took off. Some businesses moved quickly into it and made money, and some didn’t, and they got hammered.”

If the government finds this entire system alarming enough — and Schumer’s letter is likely just the beginning — it could simply shut bitcoin down, although any legislation doing so would certainly take a couple of years. Bitcoin traders insist that the government wouldn’t be able to shut it down for a number of reasons, including that it has no centralized location the way Napster did (which was shuttered in 2001, two years after its creation) and that even if the U.S. cracked down, it would still exist in other countries.

“If the USA wants to shut it down,” Wagner reasons, “the Internet has a way of detecting censorship and rallying around it. They could block bitcoin transactions, but it would be censorship.”

But in fact, because users all have identifying web IDs, the government could rather easily identify users today, make it illegal to operate a bitcoin node, and drive users away with the same scare tactics that the content industry uses on illegal downloaders. And censorship protests or not, there isn’t much American traders could do.

The reality is that a currency that has no regulator, trades on an open exchange, and can be easily stolen is one that likely won’t sit well with lawmakers. So whether bitcoins are a risky investment or not, Uncle Sam may try to keep the average American consumer from getting to make that choice.